Although DeFi has not been immune to the crypto winter, the DeFi market TVL still sits at more than $50 billion, showing that the market still has plenty of investors involved! But as with all crypto, if you’ve got profits, your tax office will want a cut. That’s why we’ve teamed up with crypto tax calculator Koinly to give you the rundown on all things DeFi tax.

DeFi tax 101

Tax offices around the world have made it pretty clear that crypto is subject to tax, but the majority have failed to release guidance on newer investment opportunities, particularly DeFi investments. In other words, it can get tricky trying to figure out your tax liability from DeFi investments!

Of course, DeFi tax varies depending on where you live and how your tax office views your investments - so it’s worth checking the specific rules where you live in Koinly’s crypto tax guides, but we’ll give a general overview here.

Generally speaking, crypto is subject to two taxes - Capital Gains Tax or Income Tax. The tax you’ll pay all comes down to whether you’re seen to have a capital gain or additional income. For DeFi, this means it all comes down to how your specific DeFi protocol works and the existing guidance from your tax office.

Sometimes, transactions you can make on various DeFi protocols will already have existing guidance from your tax office. For example, the majority of tax offices are clear that selling or trading crypto for crypto is a disposal and any gain subject to Capital Gains Tax. That applies to decentralized exchanges as much as it does to centralized exchanges. 

But for a variety of other common DeFi transactions like staking, liquidity mining, lending and yield farming, how the existing guidance applies isn’t as clear. How your DeFi protocol works determines the tax you may have to pay. 

Let’s take a look at some common transactions, popular protocols and the potential tax implications for each.

Liquidity pool taxes 

Earning passive income through liquidity pools has become one of the most popular investments in the DeFi space. On the surface, it might seem as though adding and removing your liquidity from a given pool is a tax free event, like transferring crypto between your own wallets, but it’s not quite so.

From the existing guidance of most tax offices, trading one cryptocurrency for another is a disposal and therefore a potentially taxable event if you have a gain. 

When you add and remove your crypto from liquidity pools, most of the time, you’ll exchange liquidity pool tokens (LP tokens) for your assets. So when you add liquidity, you receive LP tokens, and vice versa when you remove liquidity. 

This could be viewed as a crypto to crypto trade - meaning you may need to recognize a disposal and realize a capital gain or loss, both when you add liquidity and when you remove it.

Moreover, some tax offices have specific guidance around a concept known as “beneficial ownership”. In layman's terms, this refers to whether you or another party now benefits from owning the tokens. In the instance of liquidity pools, there is an argument that as your assets are being used to facilitate specific trades by a given protocol, despite the fact that you haven’t disposed of your crypto permanently, you no longer retain beneficial ownership of your assets, This view of adding and removing liquidity as a disposal actually makes sense for many liquidity pools as in many instances, you don’t earn new tokens as a reward, instead your LP tokens accrue value and it’s only at the point that you withdraw your assets that you realize a gain or loss. 

However, there are some liquidity pools that don’t work like this and instead pay out new tokens as a reward, and there are some that do a mix of both. Let’s take a look at a couple of examples to understand the various tax implications.

Example: Uniswap

You add liquidity to a pool on Uniswap. You receive LP tokens in return representing your share of the pool. You receive transaction fees as a reward for providing liquidity.

The value of your LP tokens increases, but you do not receive new tokens. You only realize a gain when you withdraw your liquidity from the pool by exchanging your LP tokens.

In this instance, and for any other DeFI protocols that work in this way, your tax office may view both adding and removing liquidity as a crypto to crypto trade and therefore any gain may be subject to Capital Gains Tax.

Example: Compound

You add liquidity to a Compound lending pool. You receive cTokens in return for your capital - a kind of LP token- and these cTokens accrue value as you receive rewards. Like above, both adding and removing liquidity by exchanging your cTokens may be viewed as a crypto to crypto trade and therefore any gain potentially subject to Capital Gains Tax.

As well as this though, all active Compound users receive COMP tokens as a reward which can be claimed at any point. As you’re earning new tokens, your tax office may view this as a kind of additional income, as opposed to a capital gain, and you may need to pay Income Tax based on the fair market value (FMV) of your tokens at the point you received them.

Staking taxes

Confusingly, staking can refer to two entirely different activities in the DeFi market - staking as a PoS consensus mechanism and DeFi staking. 

For the former, many tax offices have released guidance on the taxation of staking rewards as part of a Proof of Stake consensus mechanism. The majority of tax offices view staking rewards as a kind of additional income and therefore you’ll need to pay Income Tax based on the FMV of any staking rewards at the point you received them. 

Some of this guidance may also apply to DeFi staking as well, but it all comes down to how your protocol operates. We’ll use an example to explain. 

Example: SushiSwap

You can stake your SLP tokens from SushiSwap in order to earn SUSHI tokens. In this instance, you’re earning new tokens - like staking as part of a consensus mechanism - so it’s likely this may be viewed as additional income and subject to Income Tax.  But this isn’t always the case - even on the same platform.

You can also stake your SUSHI tokens to earn XSUSHI. In this instance, when you stake your SUSHI tokens, you receive XSUSHI tokens that accrue value. It’s only when you unstake your SUSHI tokens, that you’ll receive your rewards. With this in mind, this transaction is more likely to be viewed as a crypto to crypto trade and you may need to realize a disposal both at the point you stake and unstake your tokens. 

Yield farming taxes

Yield farming can refer to a huge number of investment activities, so like in all of our examples above, it depends on the specific protocol(s) you’re using in your yield farming strategy and your tax office’s existing guidance on crypto. Generally speaking, the easiest way to think of it is any time you’re earning new tokens, this is more likely to be subject to Income Tax, while anytime you’re realizing a gain by selling or swapping crypto, this is more likely to be subject to Capital Gains Tax.

How to calculate, report and file your DeFi crypto taxes

If you’re an active investor with mining income, DeFi investments, and regular trades - calculating your crypto taxes can take hours of manual admin. As well as this, some countries - like the USA - want an excruciating amount of information about each transaction.

Fortunately, that’s where our partner Koinly comes in. Save yourself hours of pain, use Koinly crypto tax calculator and follow these 5 easy steps to file your crypto taxes instead:

1. Connect all your wallets, exchanges and blockchains to Koinly. You can do this automatically via API or by importing CSV files of your transaction history. Koinly supports more than 700 integrations, including NiceHash. Learn more.
2. Grab a coffee and let Koinly do its stuff. Koinly will collate your entire crypto transaction history and identify which transactions are taxable and which aren’t. Then it’ll calculate your cost basis, capital gains or losses and the fair market value of any crypto income on the day you received it.
3. Download your crypto tax report. Download the tax report you need, when you need it. Koinly can generate a huge variety of reports for tax offices around the world including the IRS, HMRC, the ATO, the CRA and more.
4. Use your crypto tax report to file your preferred way. Hand your reports over to your accountant, upload your crypto tax report to your tax app or file by post. The choices are endless.
5. Relax - you’re done for another year. 

Get an exclusive 50% discount on your Koinly crypto tax report when you sign up to Koinly using code NICEHASH.

Disclosure

The information on this website is for general information only. It should not be taken as constituting professional advice from Koinly. Koinly is not a financial adviser or registered tax agent. You should consider seeking independent legal, financial, taxation or other advice to check how the website information relates to your unique circumstances. Koinly is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.